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December 1993, Vol. 116, No. 12

The Consumer Price Index: underlying concepts and caveats

Dennis Fixler

In 1927, Irving Fisher, in The Making of Index Numbers, wrote:

Most people have at least a rudimentary idea of a "high cost of living" or of a "low level of prices," but usually have very little idea of how the height of the high cost or the lowness of the low level is to be measured. It is to measure such magnitudes that "index numbers" were invented.1

The Consumer Price Index (CPI), produced by the Bureau of Labor Statistics, serves as an approximation of an ideal cost-of-living index (CLI).2 The CPI is a measure of the average change in the prices paid by urban consumers for a fixed market basket of goods and services." Measuring price change through the use of a fixed market basket has a long history, dating to the early 1700's.3 The theory underlying the CLI is much more recent, having been developed by A. A. Konus in 1924.4

This article reviews how the theory of the CLI provides the conceptual foundation for the CPI and the caveats governing the use of the CPI as an approximation for a CLI. To understand these warnings it is necessary to know the sources of measurement errors in prices and weights that unavoidably impede the construction of the CPI. If the measurement error is systematic, then a systematic difference may exist between the computed CPI and the true CLI, which would, in turn, affect the measured rate of price change. In this article such systematic differences are called systematic effects.5

A description of some of the prominent features of the structure and market dynamics of prices is useful because they are relevant to understanding sources of measurement error. First, consumers face a large number of different products; those who design indexes must aggregate the prices of nonidentical products into groups or strata. Second, within a product stratum, consumers face a variety of prices arising from such factors as differences in the production technology of manufacturers and the location of retail outlets. Third, price changes stem from market dynamics such as entry and exit of firms, and the expansion of existing firms. Fourth, prices routinely oscillate, due to, among other reasons, seasonal factors and periodic sales.

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1 Irving Fisher, The Making of Index Numbers, third edition (New York, Houghton Miffin, 1927), p. 2.

2 In fact, the theory of the cost-of-living index serves as the framework in which practical questions concerning the assembly of the Consumer Price Index as discussed. See BLS Handbook of Methods, Bulletin 2414 (Bureau of Labor Statistics, September 1992), pp. 176-177. See also R. Gillingham, "A Conceptual Framework for the Revised Consumer Price Index," Proceedings of the Business and Economic Statistics Section, 1974.

3 W. Erwin Diewaert, "The Early History of Price Index Research," Working Paper 2713 (Cambridge, MA, National Bureau of Economic Research, Inc., September 1988).

4 A. A. Konus, "The Problem of the True Index of the Cost-of-Living," (1924), Econometrica 7, 1939, pp. 10-29.

5 A commonly used term for a systematic difference is bias. However, there are many kinds of bias, for example, statistical bias; to avoid confusion, the term "effect" will be used instead.

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